516 / 2024-04-25 18:32:27

Financing Contract Design with Moral Hazard: Service-based Financing or Customer-based Financing

moral hazard, FinTech, service-based financing, customer-based financing

Due to contract incompleteness, manufacturers changing the production type may affect the lead time and probability of successful delivery, thus increasing the risk for financial institutions. The emergence of FinTech enables financial institutions to design financing contracts focusing on the whole trade process, thereby mitigating this moral hazard. This paper examines the productivity inefficiencies caused by moral hazard when financial institutions offer purchase order financing and factoring separately (service-based financing) and studies how to address such inefficiencies through an integrated interest pricing process (customer-based financing). We develop a game-theoretic model to analyze the strategic interaction between a financial institution and a manufacturer who can choose between normal and rush production. Under service-based financing and when the production failure rate from rush production is medium, to prevent losses from the manufacture’s option of rush production, the financial institution raises the interest rate of purchase order financing, which causes underproduction and profit loss for the manufacturer. Under customer-based financing, the financial institution simultaneously reduces the interest rate of purchase order financing and cash advance of factoring to avoid him opting rush production, thus mitigating moral hazard. Furthermore, customer-based financing is more likely to mitigate moral hazard (and increases more relative profit) for firms with low (moderate) production transparency, high (moderate) liquidity risk, highly (highly) volatile demand and low (low) margin. Our study sheds light on how financial institutions design financing contracts to mitigate moral hazard and demonstrates the value of such contracts on improving the manufacturer's production behavior and performance.